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Renewed interest in fiscal policy has increased the use of quantitative models to evaluate policy. Because of modeling uncertainty, it is essential that policy evaluations be robust to alternative assumptions. We find that models currently being used in practice to evaluate fiscal policy stimulus proposals are not robust. Government spending multipliers in an alternative empirically-estimated and widely-cited new Keynesian model are much smaller than in these old Keynesian models; the estimated stimulus is extremely small with GDP and employment effects only one-sixth as large.

In the aftermath of the global financial crisis and great recession, many countries face substantial deficits and growing debts. In the United States, federal government outlays as a ratio to GDP rose substantially from about 19.5 percent before the crisis to over 24 percent after the crisis. In this paper we consider a fiscal consolidation strategy that brings the budget to balance by gradually reducing this spending ratio over time to the level that prevailed prior to the crisis. A crucial issue is the impact of such a consolidation strategy on the economy. We use structural macroeconomic models to estimate this impact focussing primarily on a dynamic stochastic general equilibrium model with price and wage rigidities and adjustment costs. We separate out the impact of reductions in government purchases and transfers, and we allow for a reduction in both distortionary taxes and government debt relative to the baseline of no consolidation. According to the model simulations GDP rises in the short run upon announcement and implementation of this fiscal consolidation strategy and remains higher than the baseline in the long run. We explore the role of the mix of expenditure cuts and tax reductions as well as gradualism in achieving this policy outcome. Finally, we conduct sensitivity studies regarding the type of model used and its parameterization.

Recently, we evaluated a fiscal consolidation strategy for the United States that would bring the government budget into balance by gradually reducing government spending relative to GDP to the ratio that prevailed prior to the crisis (Cogan et al, JEDC 2013). Specifically, we published an analysis of the macroeconomic consequences of the 2013 Budget Resolution that was passed by the U.S. House of Representatives in March 2012. In this note, we provide an update of our research that evaluates this year’s budget reform proposal that is to be discussed and voted on in the House of Representative in March 2013. Contrary to the views voiced by critics of fiscal consolidation, we show that such a reduction in government purchases and transfer payments can increase GDP immediately and permanently relative to a policy without spending restraint. Our research makes use of a modern structural model of the economy that incorporates the long-standing essential features of economics: opportunity costs, efficiency, foresight and incentives. GDP rises because households take into account that spending restraint helps avoid future increases in tax rates. Lower taxes imply less distorted incentives for work, investment and production relative to a scenario without fiscal consolidation and lead to higher growth.

In the aftermath of the global financial crisis and great recession, many countries face substantial deficits and growing debts. In the United States, federal government outlays as a ratio to GDP rose substantially from about 19.5 percent before the crisis to over 24 percent after the crisis. In this paper we consider a fiscal consolidation strategy that brings the budget to balance by gradually reducing this spending ratio over time to the level that prevailed prior to the crisis. A crucial issue is the impact of such a consolidation strategy on the economy. We use structural macroeconomic models to estimate this impact. We consider two types of dynamic stochastic general equilibrium models: a neoclassical growth model and more complicated models with price and wage rigidities and adjustment costs. We separate out the impact of reductions in government purchases and transfers, and we allow for a reduction in both distortionary taxes and government debt relative to the baseline of no consolidation. According to the initial model simulations GDP rises in the short run upon announcement and implementation of this fiscal consolidation strategy and remains higher than the baseline in the long run.

In the aftermath of the global financial crisis and great recession, many countries face substantial deficits and growing debts. In the United States, federal government outlays as a ratio to GDP rose substantially from about 19.5 percent before the crisis to over 24 percent after the crisis. In this paper we consider a fiscal consolidation strategy that brings the budget to balance by gradually reducing this spending ratio over time to the level that prevailed prior to the crisis. A crucial issue is the impact of such a consolidation strategy on the economy. We use structural macroeconomic models to estimate this impact focussing primarily on a dynamic stochastic general equilibrium model with price and wage rigidities and adjustment costs. We separate out the impact of reductions in government purchases and transfers, and we allow for a reduction in both distortionary taxes and government debt relative to the baseline of no consolidation. According to the model simulations GDP rises in the short run upon announcement and implementation of this fiscal consolidation strategy and remains higher than the baseline in the long run. We explore the role of the mix of expenditure cuts and tax reductions as well as gradualism in achieving this policy outcome. Finally, we conduct sensitivity studies regarding the type of model used and its parameterization.